It\u2019s a scenario scary enough to induce night sweats in even the steeliest CIO. Your CEO, just back from a conference in Phoenix, strides into your office. Yesterday, he played golf with the vice president of sales for one of the big IT services companies and now he\u2019s telling you that this company could take over most of your IT functions and cut your company\u2019s IT budget in half. Not only that, they can deliver better services levels. After all, it\u2019s what they do! Our business isn\u2019t IT anyway, the CEO continues, waxing enthusiastic. And our biggest competitor just signed an outsourcing megadeal, too. Best of all, there\u2019s no need for a long, drawn-out RFP process. "Just call this guy up tomorrow," the boss says with a big smile, sliding a blue-and-white business card across your desk. He\u2019s doing you a favor. "It\u2019s practically a done deal," he concludes happily.For many CIOs, this nightmare is neither a dream nor all that uncommon. But unlike most dreams, the morning after brings consequences that are all too real. Outsourcing a particular function within IT\u2014or all of them\u2014without considerable study can have disastrous consequences that you, not your CEO, will have to solve. In the past year alone, 47 percent of companies have prematurely ended an outsourcing arrangement, according to research by Diamond Management and Technology Consultants. Forty-three percent of them brought the work back in-house, indicating it may not have been a good decision to farm out the function in the first place. "Outsourcing, onshore or offshore, if not done right or done for the right reasons, can tip things the wrong way," says Chris Jones, principal of consultancy Source:Renaissance. "It can have negative effects on IT, on the business and, ultimately, your customers."How to Get Ready for the CEOShort of locking the executive team in a tower, there\u2019s no way to prevent them from falling under the influence of high-pressure, enthusiastic vendors. Selling is what vendors do. But you can ensure you\u2019re not backed into a corner on a decision as important as outsourcing a portion of IT\u2019s portfolio. How? By having a well-thought-out and clearly articulated IT sourcing strategy already in place when your CEO comes knocking."The most mature IT organizations understand the whole of their operations. They have good metrics to track costs and service levels. They know the different points in the enterprise that could affect the IT operation as a whole," says Dane Anderson, research director of IT services and sourcing for Gartner. "They have a sourcing strategy already pulled together to defend against misleading or poorly thought-through outsourcing decisions long before the big \u2019O\u2019 word even comes down from on high."The point of such a plan is not to build an a priori case against outsourcing. The goal is to gather all the facts\u2014such as how IT fits into the overall business strategy, what the real costs and service levels are internally, how they compare with the outsourcing market, as well as input from relevant business constituents\u2014to create a fair-minded framework for making the best sourcing decision in any situation. "It\u2019s much better to proactively investigate the sourcing alternatives," says Jeffrey M. Kaplan, managing director of consultancy ThinkStrategies, "than to find yourself reacting to proposals from your superiors."Doing all this takes time and effort. But with such a politically charged decision as outsourcing, such a plan goes a long way toward keeping emotion out of the debate. "I recommend that every CIO build an internal core competency in sourcing decision making. This way, when the CEO or CFO says, \u2019I just spoke to EDS or BearingPoint and they can do all this for me\u2014why shouldn\u2019t we let them do it?\u2019 you can say, \u2019Great question! Here\u2019s why,\u2019" says Thomas Koulopoulos, executive director of Perot Systems Innovation Labs and author of Smartsourcing."And if the question hasn\u2019t been asked yet," Koulopoulos says, "be assured it will be."Tie Sourcing Strategy to Business StrategyBusiness executives have their own motivations when it comes to outsourcing IT functions. A CEO may see it as a chance to focus internal employees on core competencies or to transfer risk to a vendor. A CFO will be scouting for an opportunity to slice 30 percent off the bottom line.CIOs can have good reasons not to outsource a certain function at a particular point in time. The trouble is that the CIOs\u2019 first line of defense tends to be IT-centric, which sounds self-serving. As a result, says Phil Hatch, founder of sourcing consultancy Ventoro, "they\u2019re not getting enough traction [with executives] when they explain what might be dangerous about outsourcing a certain problem."The solution is to create a sourcing strategy that\u2019s tied to the overall business strategy. Sixty-five percent of IT organizations lack a sourcing plan, says Anderson of Gartner. "And those that do have a document collecting dust. It\u2019s like the letter to shareholders in the annual report. It\u2019s not an actionable document. It doesn\u2019t tell you how these decisions will be made."A good sourcing strategy starts with the goals of the corporation and works from that to lay out the objectives for IT. That clear connection will enable the CIO to create a decision framework to guide sourcing choices.How Dow Does ItDow Chemical\u2019s IT leadership hasn\u2019t been bashful about outsourcing\u2014or about how IT sourcing decisions fit into the big picture. "At Dow, our overall vision is to be the largest, most respected chemical company in the world," says Mack Murrell, the senior director of information systems and office facilities for the $46.3 billion chemical company. "That says a lot."What says more are the principles the company follows to achieve that goal. "Everything in IT aligns to one or more of our four strategic themes: driving financial discipline, creating sustainability, focusing on people and investing for growth," says Murrell. Keeping those principles in mind makes sourcing decisions easier\u2014and easier to sell to the business. Dow outsources between 60 percent and 85 percent of IT functions, depending on the workload and business cycle. (Most IT investments occur during profitable peaks in Dow\u2019s cyclical business.)Dow IT\u2019s sourcing decisions start with an assessment of skills available internally and externally. Then IT can hand an activity to an outsourcer, augment its own staff or do a combination of the two, depending on the task\u2019s strategic importance. However, core activities such as architecture, major technology decisions, contract management, security and senior-level relationships with the business that tie into Dow\u2019s four strategic themes stay in-house.The desire to drive financial discipline led Dow to sign a 10-year deal with Hewlett-Packard to handle its global help desk. "We don\u2019t have to spend the money to build those skills up globally," Murrell says. "[HP has] much more scale and they can worry about where the talent pools are and how to make the financials work."At the same time, Dow has kept its mainframe operations in-house, even though that\u2019s an area a lot of companies outsource without a second thought. "We looked at it because so many people were outsourcing it," says Murrell. "But we have not been able to find a company that can approach what we spend today." Again, the theme is financial discipline. Dow\u2019s internal IT resources can do the job for about 20 percent less than the leading third-party providers and the key is that Murrell knows this, has researched this and has those numbers at his fingertips.Dow\u2019s focus on growth led to Murrell\u2019s decision to insource the bulk of the application development work he once sent to Shanghai. The Chinese market is an important growth opportunity for Dow. Outsourcer Accenture is involved in Dow\u2019s Shanghai development shop, but the majority of employees work for Dow. "It was an opportunity to hire people, get to know China and be ready for doing more business there. Meanwhile, they are learning Dow work processes as they work on IT projects," says Murrell. "Our partnership with Accenture has been very helpful in that process, but we identified and are driving that opportunity, not the other way around.""What Dow has done is not unique," says Jeanne Ross, principal research scientist at MIT\u2019s Center for Information Systems Research. "But it\u2019s clearly articulated." It doesn\u2019t guarantee success, of course. In 2004, Dow ended a seven-year networking deal with EDS three years early (Dow transferred that work to IBM because it thought IBM "could provide more long-term value"). Problems may occur in the course of any outsourcing relationship but a sourcing strategy ensures that initial decisions are made in the context of where the business is headed. "It provides a common language that\u2019s understood across the company," says Murrell. At Dow, the four driving principles are beat like a drum from the CEO on down. But that\u2019s not true in all organizations. At those companies, the CIO must engage the business in conversations about the company\u2019s core mission and how IT can best help achieve it. "If you don\u2019t, you\u2019re at huge risk and so is the IT group," says Koulopoulos of Perot Systems. "Someone will come around and say, \u2019Why don\u2019t we outsource everything in IT?\u2019"How to Calculate the True Costs of Sourcing OptionsCreating a business-driven sourcing strategy is an important first step. But an apples-to-apples comparison of what it costs to insource a function versus outsourcing it must be fed into that framework. Outsourcers will always claim they can do better in terms of costs and service levels than internal IT\u2014it\u2019s what they do\u2014so building a case against outsourcing may hinge on fact-checking that claim. "You have to be able to say, \u2019Here are our actual costs and service levels. Here\u2019s what the provider can offer. Let\u2019s figure out what makes a good case,\u2019" says Gartner\u2019s Anderson.Many IT organizations lack a true understanding of their internal costs and service levels. "For years, the business put money into IT because that was the cost of doing business. But now they\u2019re asking some hard questions," says Koulopoulos. "Unfortunately, the costs are often buried and there are no benchmarks."Guesstimates won\u2019t do. To make a case for or against outsourcing an IT function, CIOs must know at a granular level how much their company spends on it internally. "You have to do it based on actual IT expenditures, not budget performance. Even labor costs at the macro level aren\u2019t good enough because one developer may be doing work in several different areas," says Harry Wallaesa, founder of IT consultancy The W Group.Better, Faster and Cheaper at VanguardJeff Dowds, IT principal, systems integration, who is in charge of delivering IT services for three of Vanguard\u2019s four lines of business, was always clear about the fact that the company\u2019s business strategy drives his IT sourcing decisions. But if you\u2019d asked him two years ago about the service levels, costs and productivity of the mostly insourced IT department, he couldn\u2019t have told you. It was a tricky place to be for an IT executive overseeing an internal development staff of 1,600, even as competitors were doing more and more outsourcing.It\u2019s easy to see why IT went the do-it-yourself route at Vanguard. The mutual fund company operates virtually, and technology is the link between the business and the customers. "We wouldn\u2019t outsource all of our technology any more than we\u2019d outsource our money management," Dowds says.But one of Vanguard\u2019s strategic objectives is to keep costs low. If IT couldn\u2019t prove it was doing better than an outside provider, the decision to eschew outsourcing could come into question. "Delivering custom-built technology in-house is expensive and we pay a premium doing that work in-house and onshore. But we\u2019re always interested in being better, faster, cheaper," says Dowds.In 2004, Dowds started to laser in on costs and quality metrics. He knew he was probably paying a premium to keep development in-house and needed to validate that investment with returns like developer productivity and software quality. But "it was a struggle to figure out how to best measure it and get the accounting right," says Dowds. "We have to do it a consistent way to justify our choice to keep development in-house."As for costs, he says, "we don\u2019t cost account ourselves to death," he says. For each project, Dowds multiplies the hourly cost for developers times the number of developer-hours required and tacks on an additional 15 percent for infrastructure costs (say, additional Unix processing horsepower or increased storage) and another 15 percent for the businesspeople who work with IT on the project. "I don\u2019t want to say it\u2019s precise," says Dowds, "but it works well."The data has enabled IT to justify its sourcing decisions to the business and stave off pressure to offshore application development. "IT is the biggest cost to the business and we don\u2019t get a free pass," says Dowds. "We have a Vanguard governance group at the most senior level and they will challenge IT on how it sources development. We have been able to show them what our costs and productivity are and how we can manage them better. Outsourcing is not the only way to drive IT costs down. We can be more efficient and more productive."When it comes to outsourcing, Dowds would never say never, though. Ten years ago, Vanguard outsourced its LAN administration in order to cut costs. Four years ago, Dowds brought that work back in-house for the same reason. In both cases, the sourcing decision achieved the desired effect. "If we discovered that our competitors were substantially lowering their costs by outsourcing and closing the gap in a material way, we\u2019d have to reexamine our decision," he says.Meanwhile, Dowds displays fiscal responsibility by employing cheaper contract labor (which usually amounts to 8 percent of IT\u2019s total labor pool) that he can shed when times get tougher. "That way, [the business] is not asking, \u2019When is IT going to wake up and outsource like everyone else?\u2019" Dowds says. Thus far, there hasn\u2019t been a case where insourcing development was so expensive or counterproductive that Dowds couldn\u2019t build a business case for it."You don\u2019t ever want to get yourself into a position where you have to outsource because you\u2019re not good at what you do," says Dowds. "You do it because there are other reasons in the business that drive you there."$100,000 Well SpentAt Henry Schein, economics weighs heavily in outsourcing decisions. "We put a ton of time into benchmarking," says CTO and Senior VP Jim Harding, who spends between $50,000 and $100,000 annually on consulting services to compare internal costs and service levels to those of major competitors and third-party providers.Harding has done limited outsourcing as IT\u2019s internal costs and quality have mostly held their own, even in areas that might not seem core to the $4.6 billion distributor of dental supplies. In fact, Harding chose not to outsource the help desk (which consists of a staff of six, supplemented with interns) because no outsourcer could touch his actual costs, which were 20 percent to 30 percent lower than third-party providers charged for the same service.He did look seriously at outsourcing his data center and went through the bidding process just to find out what the actual offers were from vendors. Their proposals were too pricey. "We weren\u2019t going to save any money doing it," says Harding. "And in the worst case, you could end up in a situation where you want an extra extension cord, and according to the contract, it\u2019ll cost an extra $40,000."That happened when he outsourced support of the Henry Schein business unit that sells computer and networking equipment to doctors and dentists. "They wanted to take over the facilities and the people but still keep it here at our site," says Harding. "And it ended up costing us more because they nickled and dimed us to death. We cut our costs significantly by bringing it back in-house."Money\u2019s not the only factor driving Harding\u2019s decision not to outsource. Less tangible issues are factored in. "Just because [the vendors] do it for a living doesn\u2019t mean they do it any better. Nobody cares about our people like we do," says Harding. "To give that over to IBM, we\u2019d have to pay their higher rates and risk losing those service levels."It\u2019s a lesson he learned the hard way. At a previous company, Harding hired an outsourcer to provide data recovery services. One day, the power went out. "Their uninterruptible power supply didn\u2019t work and our machines went down," says Harding. "And they were the so-called experts."Why Money Isn\u2019t EverythingIncorporating unpredictable or less quantifiable\u2014but equally expensive\u2014costs or benefits into a case against outsourcing is critical. "Once you have the numbers, you have to address a series of risks. The transition to the outsourcer could take longer, supplier productivity may not be as good as advertised and you may see less savings," says Jones of Source Renaissance. "There could be all kinds of changes or unknowns downstream."Getting a handle on costs and quality is a good first step. But there are other less tangible risks that should be factored into any sourcing case. At Vanguard, data security has become a huge consideration in the decision not to outsource. Dowds is considering whether to proceed with a managed service deal for that very reason. At Henry Schein, there\u2019s not much outsourcing going on anywhere because the company has been able to leverage its centralized shared service model to great financial advantage, so a sudden move to outsource major portions of IT could have a negative effect on the corporate culture or employee morale."There are things like impact on employees, public opinion, intellectual property protection, compliance\u2014[things] you may not be able to apply an accurate numeric value to\u2014that should be factored into the business case," says Hatch of Ventoro. (See "Risky Business," Page 56.)Bring the Business InTwenty years ago at the dawn of the outsourcing age, decisions about handing tech functions over to a third party were made solely by the IT department, with no input from the business. During the megadeal days of the 1990s, the pendulum swung in the opposite direction, with the business foisting outsourcing deals on IT. Today, we\u2019re somewhere in the middle. "The ideal situation would be to make the sourcing decision process a collaborative one involving relevant stakeholders," says Gartner\u2019s Anderson.At Henry Schein, Harding engages the business in the process to protect himself from sending more work offshore than he\u2019s comfortable with. For instance, when it\u2019s time for auditing internal IT costs and working with external consultants on benchmarking, Harding involves the finance department. "I bring them in and have them look at it and add their own analysis as to whether it\u2019s a fair benchmark," he says. "It provides a good check and balance for IT, and it lends some credibility to the numbers."He also publicizes internal costs and service levels monthly, explaining what the results mean in business terms, both in one-on-one meetings with the C-level suite and in IT steering committee conferences. "As long as your costs are competitive and you\u2019re delivering well, there\u2019s no pressure," says Harding. "If those start to fail, they\u2019ll start to say, \u2019Why don\u2019t we bring in some outside experts?\u2019"If there\u2019s a problem with internally delivered IT services, Harding is quick to communicate. "It can be as insignificant as an issue with e-mail or as bad as an AS\/400 core processor going down. We issue a code red and report on it at the end of the month," says Harding. "If it\u2019s something really critical, I\u2019ll call the chairman myself."Harding believes the best defense is a good offense. He learned this at Mobil Oil in 1985 during the first outsourcing gold rush. "We made all the classic mistakes," he says. "The business was making the decision, IT didn\u2019t understand our own costs, and we outsourced every single thing that was not \u2019core.\u2019" The result? "We ended up taking it all back in-house."The lesson for Harding was to involve the business early and often not only in sourcing decisions but in monitoring how well IT is delivering so the business leaders don\u2019t have the impetus to seek other sourcing options on their own. When Steve Brown was CIO of Carlson Companies, the $8.4 billion travel, hospitality and marketing conglomerate, he was selective about outsourcing. Hired in 2000, he knew that Carlson\u2019s margins were slim, and anything he could do to ease the margin pressures would help.After close examination, Brown decided the best way to provide low-cost and high-availability IT services to the business was to keep most of IT in-house as he transformed the decentralized IT function into a shared services organization. But he made certain the businesses within Carlson understood not only why he did not outsource more but also how that decision benefited them. He created a catalog of 85 services IT provided, each benchmarked against "best in class" providers."That allowed me to make sure I was provisioning services that were best in class from a quality and cost point of view," says Brown, who left Carlson in 2005. The one area where he couldn\u2019t compete was printing and document management, which he handed off to Xerox.Brown knew how important every dollar was to each of the company\u2019s businesses. So he took his services catalog and benchmarking and drilled down. He compared the IT for the hotel businesses to best in class hotels. He compared the marketing business\u2019s IT costs to best in class marketers. "It\u2019s important not just to benchmark but to be able to talk to the business in the terms that are meaningful to them," Brown says.He also tailored presentations to the CEO, CFO and COO, making it a habit to point out where service or costs were less than stellar and explaining how that might be solved either internally or through a third-party provider. "You have to own all the facts and that allowed me to have a very meaningful conversation with the business about IT and enabled them to be an informed part of the decision-making process," says Brown. "It transformed it from the typical conversation you have, which is, \u2019We need to cut some costs. Let\u2019s cut it out of IT.\u2019"When executives asked about the possibility of sourcing some application development offshore, he could tell them, "\u2019I\u2019m already looking more deeply into that and here\u2019s what I\u2019ve found so far.\u2019 They knew I was looking at every aspect of IT all the time. That created trust."The Best Laid PlansA CIO can be proactive about creating a sourcing strategy that\u2019s closely aligned with the business strategy, diligent in assessing the costs, service levels and other factors necessary to make informed comparisons between sourcing options, and politically savvy about involving the business every step of the way, yet the decision may still be made to outsource an IT function.That happened at Carlson, where last year the company signed a major outsourcing deal with IBM to handle selected IT and finance functions. Brown lobbied against the decision and ultimately resigned. "These [outsourcing] decisions are still going to be made," says Gartner\u2019s Anderson. "But you can at least force the business to take a breath. When these mandates come down, you\u2019ll at least have some initial argumentation. Worst-case scenario, if the decision proceeds, you have all the data to do a baseline comparison to what the provider is pitching you."Sometimes investing time and money in a detailed examination of sourcing options can bias executives toward signing a deal. "There\u2019s a certain momentum to the process and some may feel the obligation to follow through and set up an outsourcing relationship," says Kaplan of ThinkStrategies. "But it\u2019s a healthy exercise and can be successful even if you don\u2019t end up outsourcing anything. It\u2019s best seen as an opportunity to evaluate internal requirements and external opportunities."And one that shouldn\u2019t be done once and tossed in a drawer. A good sourcing strategy should be revisited at least once a year, experts say. "You need to keep an eye out on a continuous basis," says Kaplan. "Your own business and the IT services market is changing so rapidly."The continued effort will pay off one way or another, not only preventing against bad outsourcing decisions but also uncovering outsourcing opportunities you might not have considered. "Even if outsourcing is not on the table, start building your case," says Gartner\u2019s Anderson. "Not to defend against it necessarily but to be prepared to have that discussion based on a business case."